Understanding Interest Obligations in Japan: Agreed Interest, Legal Interest, and the Impact of the Interest Rate Restriction Act

Japanese Attorney at Law - Bengoshi L.L.

• 9 min read

Interest on monetary obligations is a fundamental aspect of most financial transactions. In Japan, the charging and calculation of interest are governed by a combination of general principles in the Civil Code (Minpō) and specific, stringent regulations, most notably the Interest Rate Restriction Act (Risoku Seigen Hō - 利息制限法). For businesses and individuals involved in lending or borrowing, or any contract stipulating interest payments under Japanese law, a clear understanding of these rules—covering agreed interest, the recently reformed legal interest rate, and the strictures of the Interest Rate Restriction Act—is essential.

Under Japanese law, "interest" (risoku) is generally understood as compensation or consideration paid for the use of a principal sum of money (or other fungible goods, though money is the most common context). It is typically calculated based on the principal amount, the duration of its use, and an agreed-upon or legally stipulated rate.

It's crucial to distinguish true interest from other payments that might colloquially be referred to as "interest" but have a different legal character:

  • Default Interest / Damages for Late Payment (Chien Risoku - 遅延利息 / Chien Songaikin - 遅延損害金): When a monetary obligation is not paid by its due date, the creditor can typically claim damages for the delay. Article 419 of the Civil Code governs this, often referring to such damages as "interest for delay." However, legally, this is considered compensation for loss caused by the default, not true interest for the use of money under the original agreement. While it's often calculated using an interest rate (either agreed as a default rate or the legal interest rate), its nature is that of damages.
  • Intercalary Interest (Chūkan Risoku - 中間利息): In cases of lump-sum damages awards for future losses (e.g., lost future income in personal injury cases), an amount representing "intercalary interest" is deducted. This accounts for the fact that the recipient can earn interest on the lump sum received upfront (Civil Code Articles 417-2 and 722, paragraph 1). This is a calculation method for damages, not interest in the lending sense.
  • Fees, Commissions, and Other Charges: Various fees, commissions, handling charges, or investigation fees associated with a loan or financial transaction are generally not considered true interest unless specific laws, like the Interest Rate Restriction Act, "deem" them to be interest for regulatory purposes (discussed later).

Types of Interest Obligations

Interest obligations in Japan primarily arise in two ways:

  1. Agreed Interest (Yakujō Risoku - 約定利息): This is interest that accrues based on a contractual agreement between the parties. It is most commonly found in loan agreements (kinsen shōhi taishaku - 金銭消費貸借 – loans for consumption of money). Parties are generally free to agree on the interest rate (yakujō riritsu - 約定利率), but this freedom is significantly constrained by the Interest Rate Restriction Act.
  2. Statutory or Legal Interest (Hōtei Risoku - 法定利息): This is interest that accrues by operation of law in specific situations defined by statute, even without an explicit agreement for interest. For example, if a buyer of goods that produce "fruits" (e.g., rental income from a property, dividends from shares) delays accepting delivery, the seller may be entitled to statutory interest on the purchase price for the period of delay (Civil Code Article 575).

Interest Rates (Riritsu - 利率)

1. Agreed Interest Rate (Yakujō Riritsu):
As mentioned, this is set by the contract. If an agreement stipulates that interest is payable but fails to specify a rate, the statutory/legal interest rate will apply.

2. Statutory/Legal Interest Rate (Hōtei Riritsu - Civil Code Article 404):
A major reform in the 2020 revision of the Civil Code was the introduction of a variable legal interest rate, replacing the previous fixed rates (which were 5% per annum for civil matters and 6% per annum for commercial matters, a distinction now abolished).

  • Initial Rate (from April 1, 2020): The legal interest rate started at 3% per annum.
  • Variable Mechanism: The rate is subject to review every three years. The review mechanism is as follows:
    • A "base rate" (kijun wariai - 基準割合) is calculated. This base rate is the average of the contracted interest rates on new short-term loans (less than one year) extended by banks in Japan each month over a 60-month (5-year) period, specifically looking at the period from six years before to two years before the first day of the calendar year in which the review period begins (this average is then rounded down if it has a fraction less than 0.1%).
    • This current base rate is compared to the base rate from the most recent period when the legal interest rate was last changed (or the base rate at the time of the 2020 reforms if no change has occurred yet).
    • If the difference between these two base rates is 1 percentage point or more (either up or down), the legal interest rate is adjusted by that difference (any fraction of a percentage point in the difference is discarded).
    • For example, if the current legal rate is 3% and its corresponding base rate was 1.5%, and the newly calculated base rate for the current review period is 2.8%, the difference is 1.3%. Since this is 1% or more, the legal interest rate would increase by 1% (1.3% rounded down) to become 4%. If the new base rate was 1.9%, the difference (0.4%) is less than 1%, so the legal rate would remain unchanged at 3%.
  • Application of Legal Rate: The legal interest rate is used:
    • When parties agree to interest but not a specific rate.
    • For statutory interest obligations that do not specify a rate.
    • Crucially, as the default rate for damages for late payment of monetary obligations (default interest) under Article 419 of the Civil Code, if the parties have not agreed on a different default interest rate (and subject to the caps under the Interest Rate Restriction Act).

The shift to a variable legal interest rate aims to better reflect prevailing market conditions, though its review cycle and adjustment mechanism are designed for gradual changes rather than rapid fluctuations.

Compound Interest (Jūri - 重利 / Fukuri - 複利)

Compound interest, or interest on accrued interest, is also addressed:

  • Contractual Compound Interest: Parties can agree to compound interest. Such agreements are generally valid, provided they do not violate public policy (Civil Code Article 90) or the stringent provisions of the Interest Rate Restriction Act.
  • Statutory Capitalization of Interest (Civil Code Article 405): If interest for one year or more is in arrears, and the debtor fails to pay this overdue interest despite a demand from the creditor, Article 405 grants the creditor the right (a formative right, not an automatic effect) to add the overdue interest to the principal. This newly enlarged principal will then accrue interest. This provision acts as a default mechanism if not otherwise agreed. Legal commentaries suggest that this statutory right to capitalize applies primarily to true interest, and its application to default interest (damages for delay) is more nuanced and generally not presumed for all types of debts without specific agreement or clear legal basis, though it has been applied by analogy in some loan contexts.

The Interest Rate Restriction Act (Risoku Seigen Hō - 利息制限法)

The Interest Rate Restriction Act (IRRA) is a cornerstone of Japanese financial regulation, imposing strict limits on interest rates for money lending contracts (kinsen shōhi taishaku) to protect borrowers from usury.

Key Provisions and Implications:

  1. Scope of Application: The IRRA primarily applies to contracts for the loan of money for consumption. It generally does not apply to other types of contracts like lease agreements or credit sales financing by sellers, though specific facts can sometimes blur these lines if a transaction is structured to evade the Act.
  2. Maximum Interest Rates (Upper Limits - Jōgen Riritsu, IRRA Art. 1): The Act sets tiered maximum annual percentage rates based on the principal amount of the loan:
    • Principal less than ¥100,000: 20% p.a.
    • Principal of ¥100,000 or more but less than ¥1,000,000: 18% p.a.
    • Principal of ¥1,000,000 or more: 15% p.a.
  3. "Deemed Interest" (Minashi Risoku - みなし利息, IRRA Art. 3): To prevent circumvention of the rate caps, Article 3 of the IRRA stipulates that any money paid by the borrower to the lender in connection with a money loan, other than the repayment of principal, is "deemed" to be interest, regardless of its name (e.g., fees, discounts, charges, investigation fees). There are limited exceptions, such as genuine third-party costs for contract conclusion (e.g., notary fees, stamp duty) and legitimate debt repayment expenses.
  4. Consequences of Exceeding the Limits (IRRA Art. 1): Any contractual stipulation for interest that exceeds these statutory maximum rates is void (mukō) as to the excess portion.
    • Treatment of Excess Payments: If a borrower pays interest in excess of the IRRA limits, the excess amount is not legally owed. Such payments are automatically applied by law: first, to cover any outstanding permissible interest, and then to reduce the outstanding principal balance.
    • Right to Reclaim Overpayments (Kabarai-kin - 過払金): If, after these applications, the principal is fully repaid and there is still an overpayment (i.e., the borrower has paid more than the principal plus the maximum legally permissible interest), the borrower has a claim for unjust enrichment (futō ritoku) to recover this overpaid amount (kabarai-kin) from the lender. The old IRRA provision (former Art. 1(2)) that could prevent recovery of "voluntarily" paid excess interest was abolished in 2006 (fully effective 2010), solidifying the borrower's right to reclaim.
  5. Interest Deducted in Advance ("Discounted Interest" - Tenbiki Risoku - 天引き利息, IRRA Art. 2): If the lender deducts interest from the loan principal at the time of disbursement (e.g., lends ¥1,000,000 but deducts ¥150,000 as upfront interest, giving the borrower ¥850,000), the IRRA has specific rules. The actual amount received by the borrower (¥850,000 in this example) is treated as the "calculation principal" for determining the maximum permissible interest. If the amount deducted as interest exceeds the permissible interest calculated on this received amount, the excess portion of the deduction is deemed to be a repayment of the contractual principal (¥1,000,000 in this example).
  6. Agreed Damages/Penalties for Default (IRRA Arts. 4 and 7): The IRRA also caps the rates that can be agreed upon for liquidated damages or penalties for late payment (default interest).
    • For general loans, Article 4 provides that such agreed default damages cannot exceed 1.46 times the applicable maximum interest rate under Article 1. (E.g., if the Art. 1 cap is 15%, the default damages cap is 15% * 1.46 = 21.9% p.a.).
    • For "business-purpose money loans" (eigyōteki kinsen shōhi taishaku - 営業的金銭消費貸借) by certain lenders, Article 7 sets a flat cap of 20% p.a. for default damages.
      Any agreement for default damages exceeding these caps is void as to the excess. If no specific default damages rate is agreed, then the generally applicable legal interest rate (now variable, starting at 3% p.a.) would apply, as per Civil Code Art. 419.
  7. Historical "Grey Zone Interest" and Reforms:
    For many years, a "grey zone" of interest rates existed in Japan. This was due to a discrepancy between the IRRA's civil law caps (15-20%) and the higher cap under the Investment Act (Shusshi Hō - 出資法), which set criminal penalties for usury only above its (historically much higher) threshold. Some lenders charged rates in this grey zone. The now-abolished "deemed valid payment" provision in the former Money Lending Business Act (Kashikingyō Kisei Hō, now Kashikingyō Hō) further complicated matters by allowing lenders, under certain strict documentation requirements, to retain grey zone interest if "voluntarily" paid.
    Major legal reforms, culminating around 2006-2010, largely eliminated this grey zone. Key changes included:
    • Lowering the criminal interest rate cap under the Investment Act to 20% p.a. (aligning it more closely with the highest IRRA cap).
    • Abolishing the "deemed valid payment" system.
    • Strengthening administrative sanctions against lenders charging rates above IRRA limits, even if below the (new) criminal threshold.
      These reforms have significantly strengthened borrower protection against high interest rates.
  8. Special Rules for Business-Purpose Loans by Lenders (Eigyōteki Kinsen Shōhi Taishaku): The IRRA and the Lending Business Act contain some special provisions for loans made by registered money lenders in the course of their business, for example, regarding how the principal amount is calculated for applying the tiered interest caps when multiple loans exist between the same lender and borrower ("deemed principal" rules, IRRA Art. 5), and slightly different rules for what can be excluded from "deemed interest" (IRRA Art. 6). Guarantee fees paid by the main debtor in connection with such loans can also be aggregated with interest for the purpose of IRRA caps under certain conditions (IRRA Art. 8).
  • Clarity in Agreements: Always clearly stipulate agreed interest rates, calculation methods, and any rates for default interest. Ambiguity will likely lead to the application of the (variable) legal interest rate.
  • Compliance with IRRA: For lenders, particularly those engaged in money lending as a business, strict compliance with the Interest Rate Restriction Act is paramount. Failure to do so can render interest claims unenforceable and lead to obligations to refund overpayments. Accurate record-keeping and compliant documentation are crucial.
  • Borrower Awareness: Borrowers, especially individuals and small businesses, should be aware of their rights under the IRRA regarding maximum interest rates and the treatment of various fees and charges.
  • The New Variable Legal Rate: All parties should be cognizant of the new variable legal interest rate. While it started at 3% in 2020, it has the potential to change every three years, which could affect the calculation of unspecified interest or default damages in long-term arrangements if not specifically addressed in the contract.

Conclusion

Interest obligations under Japanese law are shaped by a dynamic interplay between the parties' freedom to contract, the default rules set forth in the Civil Code (including the new variable legal interest rate regime), and the robust borrower protections mandated by the Interest Rate Restriction Act. While contractual autonomy allows for tailored agreements, the IRRA imposes non-waivable ceilings on interest and related charges for money loans, reflecting a strong public policy concern for preventing usury. For any entity involved in transactions where interest is a component, a diligent approach to understanding and complying with this multifaceted legal framework is indispensable for sound financial and legal management in Japan.